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Violation of Public Policy and the Denial of Deductions

By Edward J. Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D.

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EXECUTIVE
SUMMARY

Under the judicial
public policy doctrine, a deduction will be
disallowed if allowing the deduction would
violate public policy. In 1969, Sec. 162(f)
codified this doctrine with respect to
expenses deductible under Sec. 162 and
limited the scope of the doctrine to
expenses attributable to fines and penalties
paid to the government.

The courts have broadly read Sec. 162(f)
to apply to criminal and punitive civil
fines and penalties and, in some cases,
fines and penalties paid to nongovernmental
entities. Sec. 162(f) is also applied to
payments that are part of settlement
agreements.

Because Sec. 162(f) does not explicitly
affect Sec. 165, the IRS and many courts
have held that Sec. 165 losses other than
those attributable to fines and penalties
are still subject to disallowance under the
public policy doctrine.

In July 2010, the Wall Street Journal
reported that BP may be able to reduce its U.S.
tax bill by $10 billion as a result of the money it
set aside for oil spill claims.1 This news has reopened the
debate on the deductibility of restitution payments
and the proper role of the denial of deductions that
appear to violate public policy.

The Internal
Revenue Code is designed to tax income. The fact that
a taxpayer earned income in an illegal activity does
not make the income exempt from taxation.2 Likewise, taxpayers are
entitled to deduct expenditures incurred to produce
the illegal income.3 To deny the deduction
would revise the tax from one on net income to one on
gross receipts.4

What is less certain
is the deductibility of expenditures that violate
federal or state laws or national or state public
policy. This uncertainty is the result of the basic
policy conflict between not using the income tax to
modify behavior and not allowing a deduction that
would diminish the effect of government-imposed fines
and penalties designed to deter or punish
behavior.5 In 1969, Congress enacted
Sec. 162(f) to clarify and limit the types of
nondeductible expenditures that are deemed to violate
public policy. It chose to limit the nondeductibility
to fines and penalties paid to a government.
Nevertheless, disagreements and confusion have
continued over the scope of Sec. 162(f) and its impact
on other sections such as Sec. 165.

This
article examines the issues and limitations of
deductions under Secs. 162(f) and 165 and the
violation of public policy doctrine raised in
recentcases.

Public Policy Doctrine

Initially the Code was silent as to the
deductibility of the payment of fines and penalties.
Consequently, the courts decided to deny the deduction
of these expenditures on the grounds that no deduction
should be allowed for payments that violate public
policy.6

The scope of the
public policy doctrine was well summarized by the
Supreme Court in Tellier.7 In that case, the Court
allowed a deduction for legal fees paid to defend
against criminal charges, stating that a deduction
would be denied under the doctrine only if allowing
the deduction would “frustrate sharply defined
national or state policies proscribing particular
types of conduct.”8 The national or state
policies that are frustrated must be “evidenced by
some governmental
declaration of them.”9 In addition, the “test on
nondeductibility always is the severity and immediacy
of the frustration resulting from allowance of the
deduction.”10
Under this approach, the limitation based
on violation of public policy doctrine is very
narrow.

Sec. 162(f)

In the Tax Reform
Act of 1969, Congress decided to codify the public
policy doctrine by enacting Sec. 162(f) in the hope
that it would eliminate the questions and conflicts
raised in various cases.11 This subsection provides
that “[n]o deduction shall be allowed under subsection
[162](a) for any fine or similar penalty paid to a
government for the violation of any law.” The Code
contains no further explanation of this rule. The
Senate Finance Committee report states: “This
provision is to apply in any case in which the
taxpayer is required to pay a fine because he is
convicted of a crime (felony or misdemeanor) in a full
criminal proceeding.”12 The committee report
goes on to note that “[t]he provision for the denial
of the deduction for payments in these situations
which are deemed to violate public policy is intended
to be all inclusive. Public policy, in other
circumstances, generally is not sufficiently clearly
defined to justify the disallowance of
deductions.”13

Civil
Penalties

The regulations expand the scope of
the denial.14 Although the Senate
report refers to fines for conviction of a crime, the
regulations expand the scope of the section to include
guilty and nolo contendere pleas. More important, the
regulations apply Sec. 162(f) to civil penalties
imposed under federal, state, and local law. This
extension appears to conflict with the Code itself and
the committee reports explaining the provision.
Treasury justified the extension by its conclusion
that the reference to criminal penalties in the
committee reports was really only an example and not
intended to be taken as a true limitation.15

The validity of
applying Sec. 162(f) to civil penalties has been
questioned. The Tax Court in Tucker16 pointed out that the
legislative history can be read to exclude civil
penalties from the scope of Sec. 162(f). Without
actually resolving the conflict in the reading of the
legislative history, the Tax Court appears to have
accepted the extension by concluding that the purpose
of Sec. 162(f) was to codify prior cases and that
these cases did in fact deny deductions for civil
penalties. In MiddleAtlantic
Distributors,17 the Tax Court concluded
that Sec. 162(f) definitely covers civil penalties,
stating that “certainly, however, by 1972 it was clear
that Sec. 162(f) was intended to include civil
penalties which in general terms serve the same
purpose as a fine exacted under a criminal statute.”
The Court of Claims reached a similar conclusion about
the scope of Sec. 162(f) in Meller.18

Not all civil
penalties are nondeductible. The Tax Court in Southern Pacific
Transportation Co.19 stated that the use of
the phrase “similar penalties” was included to
distinguish nondeductible punitive penalties from
deductible remedial penalties rather than to
distinguish civil from criminal sanctions.20 (This distinction is
discussed more fully below.) Finally, the regulations
expand the scope to include settlements of actual or
potential criminal or civil fines and penalties.

The IRS expanded the provision even further in Rev.
Rul. 79-148.21 In this ruling, the
taxpayer pled no contest to violating a federal law
restricting sales to a foreign country. The taxpayer
offered to contribute the amount of the maximum fine
that the court could impose to a charitable
organization in exchange for a suspended sentence and
probation. The court accepted the offer. The ruling
concludes that the payment was nondeductible. It was
not a charitable contribution because it was not
gratuitous and the taxpayer expected a return
benefit.22 The regulations include
in the definition of fines and penalties amounts paid
in lieu of actual or potential fines or penalties.
Since the taxpayer made the contribution to avoid the
imposition of a fine, it came within the regulations’
definition of a penalty and was held nondeductible
under Sec. 162(f).

Observation: The ruling does not
discuss the fact that the money was given to a charity
rather than a governmental agency as required by a
literal reading of the statute. Thus, the ruling
expands the scope of Sec. 162(f) to include
nongovernmental payments without explanation.

Payments to Nongovernmental Entities

The extension of Sec. 162(f) to payments made to
persons or entities other than governmental units
appears to be accepted by the courts, but with
limitations. In Bailey,23 the taxpayer was ordered
to pay a $1,036,000 civil penalty for violating the
Federal Trade Commission Act. The district court
allowed the taxpayer to apply the penalty toward
settlement of his potential class action liability.
The Sixth Circuit confirmed the nondeductibility of
the payment. It concluded that although the cash was
directed to the class action liability, that did not
change the fact that it was still a civil penalty.
Specifically, the origin of the liability was a fine
payable to the government; therefore, it remained a
fine even though the funds were paid to a
nongovernmental entity.

The Tax Court relied on
the appellate decision in Bailey to conclude
that a restitution payment was a nondeductible fine
paid to a government in Waldman.24 The court reasoned that
even though a fine payable to a government is allowed
to be paid directly to a third party, that does not
change the fact that it was a fine payable to a
government. The actual recipient of the money is not
determinative.

In Allied-Signal
Inc.,25 the Third Circuit
approved and clarified the extension. In the court’s
opinion, a fine or penalty is deemed paid to a
government if, instead of having the taxpayer make the
payment directly to the government, a court directs
the payment to be made to a third party. The court
quoted the decision in Waldman: “We do not
believe that a government must actually ‘pocket’ the
fine or penalty to satisfy the ‘paid to a government’
requirement.” The court continued: “We find no
practical difference between a situation where a fine
is paid to the Treasury and the government then
expends that money for a public purpose, and a
situation where the fine is paid directly into a fund
to benefit the public at the direction of the
government.” This clarification is consistent with the
earlier cases, since the funds would have been paid to
the government if the courts had not allowed the
alternate payment. In conclusion, if the origin of the
liability is a fine payable to a government, it
remains a nondeductible fine regardless of the actual
recipient of the cash.

Observation: There was an
interesting dissent from the decision in Allied-Signal
arguing that the Code’s requirement of a payment to a
government should not be expanded to payments to third
parties. In the dissent’s opinion, if Congress
intended to include these payments, they should have
written the Code as such and not used the plain
language “paid to a government.” If the courts
continue to limit the extension to payments to third
parties at the government’s or court’s direction or
acceptance, the extension is reasonable.

Compensatory Damages

As
previously stated, the regulations appear to expand
the list of nondeductible payments. They also create
an exclusion. Regs. Sec. 1.162-21(b)(2) states that
“[c]ompensatory damages . . . paid to a government do
not constitute a fine or penalty.” Therefore, certain
payments to governments, even if they are the result
of a criminal or civil suit, will be deductible.

The scope of this exclusion is discussed in Letter
Ruling 8704003,26 which ruled on the
deduction of a settlement payment that arose from an
anti-dumping suit. It cites Middle Atlantic Distributors27 for the proposition that
penal or punitive assessments are nondeductible,
whereas remedial assessments are deductible. Punitive
assessments are designed to enforce the law, whereas
remedial assessments are compensatory and are computed
based on the harm done to the governmental unit
assessing the penalty or to a third party the
government is trying to protect. The fact that the
assessment is used to mitigate harm or injury does not
prevent the assessment from being punitive and
therefore nondeductible.

Punitive
vs. Remedial Payments

Distinguishing between
deductible and nondeductible payments based on whether
they were intended to be punitive or remedial has
resulted in some interesting court cases. For example,
in Waldman,28 the Tax Court had to
decide whether a restitution payment was remedial or
punitive. The taxpayer pled guilty to one count of
conspiracy to commit grand theft. He was sentenced to
1–10 years in prison, but the sentence was stayed
based on a restitution payment to the victims. The
court had to examine the state law and the initial
judge’s decision in detail to decide which was the
primary purpose for the restitution payment in this
case. The court decided that the primary purpose was
punitive, and therefore it was a nondeductible
fine.

Another frequently cited and important case
involving remedial versus punitive payments is Allied-Signal.29 In this case, the
taxpayer pled nolo contendere to a 1,940-count
indictment for waste and water pollution resulting
from its manufacturing of Kepone. The trial judge
imposed a fine of $13,240,000 but indicated he wanted
the money used to help those persons harmed by the
pollution. The taxpayer met with the judge to discuss
the creation of a fund to remove the pollution and
help those harmed. The judge indicated that he would
be willing to reduce the fine if the trust containing
the money was actually created. Allied-Signal funded
the trust with $8 million, and the judge reduced the
fine by $8 million. The taxpayer deducted the $8
million, arguing that the amount was deductible since
it was a voluntary payment designed to compensate
those harmed.

The Third Circuit rejected the
taxpayer’s argument. It first considered whether the
fact that a payment is voluntary would affect its
classification. The court stated that assuming that
the voluntariness of the payment was relevant, the
facts indicated that the contribution was a quid pro
quo for a reduction in the criminal fine and thus was
not voluntary.

The court also rejected the
argument that the payment was compensatory and
therefore deductible. It found that the fact that the
funds were used to benefit those harmed does not make
it compensatory. A compensatory payment is one that is
awarded to a specific victim based on injuries
suffered. According to the court, Allied-Signal’s
contribution to the fund served a general public
purpose. Since all payments to governments are
ultimately used for general public purposes, accepting
Allied-Signal’s argument that this general trust fund
designed to mediate the harm done was a compensatory
payment would, in the court’s words, nullify Sec.
162(f). Thus, the contribution to the fund was a
nondeductible fine.

Not all courts accept the
remedial versus punitive approach to deciding the
deductibility of fines. In Colt Industries,
Inc.,30 the taxpayer paid and
deducted $1.6 million it paid to the Pennsylvania
Clean Air and Clean Water funds as part of a consent
decree. The decree labeled the payment a civil
penalty. The taxpayer argued that the penalty was not
punitive and was therefore deductible.

The
Federal Circuit rejected the taxpayer’s argument and
held the payment nondeductible. According to the
court, the regulations under Sec. 162(f) do not make a
distinction between punitive and remedial penalties.
Since Treasury is authorized to issue these
regulations, they should be followed. Therefore, all
civil fines and penalties are nondeductible. Whether
the purpose of the fine is punitive or remedial is not
relevant.

The court of appeals also addressed the
limitation on nondeductibility contained in Regs. Sec.
1.162-21(b)(2). This exception removes compensatory
damages from the list of nondeductible expenditures.
Because the law under which the penalty was levied did
not authorize the government to seek compensatory
damages, the civil penalty paid by Colt Industries was
not compensatory and therefore was not within the
scope of the exceptions, according to the court. As an
example of an item within the exception, the court
referred to 15 U.S.C. Section 15(a), which allows the
government to recover actual damages sustained and
court costs. The appellate court’s approach to the
regulation would greatly expand the list of
nondeductible expenditures by severely limiting the
payments that qualify as compensatory damages.31

Origin of the Liability

Assuming
the courts continue to distinguish between
nondeductible punitive penalties and deductible
remedial penalties, the question becomes how to make
the distinction. In Bailey,32 the Sixth Circuit cited
Middle Atlantic
Distributors for the proposition that the
origin of the liability should determine its
objective. It also cited the Tax Court’s decision in
Southern Pacific
Transportation Co.33 for the conclusion that
nondeductible penalties are those designed to enforce
the law or as punishment, whereas deductible penalties
are those imposed to encourage prompt compliance with
a requirement of the law or to compensate a party for
expenses incurred because of a violation of the law.
Since Bailey’s penalty was the result of his failure
to obey an FTC consent order, the payment was designed
to enforce a law and was a nondeductible penalty. The
inclusion of the distinction between enforcement of a
law and prompt compliance is likely to result in more
nondeductible penalties, since prompt compliance
penalties will be limited to those resulting from a
failure to act within a set deadline, whereas
enforcement will encompass most other penalties.

Treasury was more specific as to the proper
analysis of a penalty in a Chief Counsel Field Service
Advice memorandum.34 According to the
memorandum, it is first necessary to determine all the
facts and circumstances leading up to the litigation
as well as the true substance and nature of the claim.
If no lawsuit is instituted, attention must be paid to
the documents, letters, and testimony surrounding the
claims. Based on this information, the proper
classification of the payment can then be made.

Settlements

As previously
mentioned, the regulations expand the scope of Sec.
162(f) to include settlements of actual or potential
liabilities for fines or penalties. In analyzing the
deductibility of the settlement payment, the courts
have looked to the origin of the underlying
liability.35 The IRS Office of Chief
Counsel used a two-step approach to classifying
settlements.36
The first step is to analyze the underlying
statute. If it is punitive, it is a penalty. If it is
remedial, the settlement does not come under Sec.
162(f). If the statute has aspects of both, the
settlement agreement must be examined to determine
which aspect of the law is the origin of the
settlement.

In these situations, the wording in
the settlement agreement will be carefully considered.
For example, in Letter Ruling 7736040,37 the attorneys carefully
drafted the settlement agreement to state that the
payment was compensatory and not a fine or penalty.
This was important in the conclusion that the payment
was deductible and implies that an agreement stating
that the penalty is compensatory and not punitive will
be determinative.

However, it is important that
too much reliance not be placed on the wording of a
settlement. Recently a district court was asked to
rule on a taxpayer’s motion for summary judgment that
a payment to settle a Medicare fraud claim was
deductible because the agreement stated the payments
were nonpunitive.38 The court held that
summary judgment was inappropriate. The judge
explained: “Because of the conflicting language in the
agreements, the placement of the nothing-punitive
language, and its wording, I conclude that the
contract is ambiguous” and not suitable for summary
judgment. In other words, just because the agreement
states it is nonpunitive does not mean it is
deductible. The existence of any ambiguity may lead a
court to review the payment under the two-step process
described above rather than accept the agreement as
determinative.

Cavaretta

The Cavaretta case39 examines several aspects
of the rules concerning the deductibility of fines and
penalties. Peter Cavaretta opened his dental practice
in 1970. In 1995, Karen Cavaretta, who worked in her
husband’s dental practice, started billing one of the
insurance companies for procedures that Peter had not
performed. The fraud was discovered, and Karen pled
guilty to one count of health care fraud. She stated
that Peter did not know of the fraud and that the
money was reported as revenue on the dental practice’s
tax return. Karen was sentenced to 18 months in prison
and 2 years of supervised release. The judge did not
order either a fine or restitution but did attach a
letter to the sentencing judgment stating that Karen
would pay the insurance company $600,000 in full
settlement of all civil claims. Peter actually made
the payments and deducted them on his Schedule C.
These payments created a net operating loss, which
Peter carried back. The government denied the
carryback refund claims.

As the judge in the
case noted, the case is interesting because the
government did not argue that the payments were
nondeductible. Instead it said that the payments were
deductible as losses in a transaction entered into for
profit under Sec. 165(c)(2) and not as business
expenses under Sec. 162. The implication of the
government’s argument is that although they were
deductible in the year paid, the amounts could not be
included in the calculation of the net operating loss
carryback.

Although the government did not argue
against deductibility, the court first analyzed
whether the restitution payments were deductible or
nondeductible. All the paperwork indicated that the
payments were restitutions and not fines or penalties.
In addition, Karen was sentenced to time in jail.
Therefore, the payments were not designed to be
punitive but to reimburse the insurance company for
its excess payments. As such, they were not fines or
penalties but deductible restitution payments.

The main question considered by the court was
whether the restitution payments was deductible under
Secs. 162 or 165. The government argued that the
Second Circuit decision in Stephens40
concluded that restitution payments, if
deductible, are only deductible under Sec. 165. As
support it quoted from the decision:

[A] restitution payment,
such as is involved herein, is not an “ordinary and
necessary” expense as required by section 162(a) but
rather gives rise to a loss in a “transaction entered
into for profit” under section 165(c)(2).

As
the Tax Court pointed out, the government’s argument
ignored the critical phrase “such as is involved
herein.” The restitution in Stephens resulted
from a conviction for criminally defrauding an
employer. It was not associated with a business and so
could not meet the requirements of Sec. 162.
Therefore, the deduction, if permitted, would have to
be under Sec. 165(c)(2). The case did not involve an
expenditure that arose in a business, and therefore
the decision in Stephens does not
preclude a deduction for restitution payments under
Sec. 162.

It is interesting that the decision
in Cavaretta
does not refer to Ostrom41 and the cases and
rulings cited therein. In Ostrom, the
taxpayer made fraudulent misrepresentations concerning
his company’s financial statements to encourage an
investor to purchase stock. The investor sued Ostrom
and obtained a judgment against him. The Tax Court
permitted Ostrom to deduct the payment of the judgment
as a business expense under Sec. 162. The court
supported its decision by citing Helvering v.
Hampton,42 in which the Ninth
Circuit permitted a business deduction for a judgment
based on fraudulent activities related to the
business, and Caldwell &
Co.,43 in which the Sixth
Circuit allowed a business deduction for payment of a
judgment for fraud. Finally, the court in Ostrom pointed out
that the IRS had adopted the conclusions reached in
these cases in Rev. Rul. 80-211,44 which allowed a business
deduction for punitive damages for fraudulent acts and
contractual violations. Going forward, there should be
no question that taxpayers can take deductions under
Sec. 162 as well as Sec. 165 for deductible payments
for civil fines and penalties.

The court in
Cavaretta
then analyzed whether the restitution payment was an
ordinary and necessary expense of Peter’s dentistry
practice. They noted that it arose from a contract
between Peter and the insurer, that Peter credibly
testified that he would have lost his business if he
did not make the payment, and that the actual payment
was less than what would have resulted from
litigation. The court concluded that the payment was
in fact an ordinary and necessary expenditure of
Peter’s business.

The final potential stumbling
block for the deduction was the fact that Peter made
the payment, but the wrongdoing was Karen’s. Under
Lohrke,45 third-party payments can
be deductible in certain circumstances. However, in
this case the court felt that the Musgrave46 decision was more
applicable than Lohrke. In Musgrave an
employer was permitted to deduct payments made to a
client from whom an employee embezzled money. The
court permitted the deduction because it was designed
in part to avoid a lawsuit and in part to protect the
employer’s reputation. The Cavaretta facts are
similar to those in Musgrave;
therefore, according to the Tax Court, Peter could
deduct the payment as an ordinary and necessary
business expense under Sec. 162.

The conclusion
from Cavaretta is that
civil restitution payments made by a business can be
deductible and that they can fall under Sec. 162, but,
to the extent such payments arise from personal and
not business actions, a deduction, if allowed, will be
restricted to Sec. 165. However, restitution paid in
lieu of a fine, as in Allied-Signal, is
nondeductible since it will be considered a fine and
not a restitution payment.

Treasury’s Additional Extensions

Congress modified the Code to deny a business an
ordinary and necessary deduction for fines and
penalties in Sec. 162(f). Through regulations and
other guidance, Treasury has extended this denial to
deductions permitted under other Code sections.

Sec. 212 permits a deduction for expenditures
incurred to produce income. Regs. Sec. 1.212-1(p)
states that no deduction is allowed under Sec. 212 for
the payment of a fine or penalty that would not be
deductible under Sec. 162(f). Therefore, the
regulations extend the denial of a deduction for fines
and penalties from primary businesses to secondary
businesses and other income-producing activities. This
consistent approach (primary and secondary business)
adopted by Treasury results in treating taxpayers
engaged in all income-producing activities
equally.

Treasury also extended the rule to an
indirect deduction. The flush language under Regs.
Sec. 1.471-3, Inventories at Cost, states:
“Notwithstanding the other rules of this section, cost
shall not include an amount which is of a type for
which a deduction would be disallowed under section
162(c), (f), or (g).” In other words, the cost of
inventory will not include fines or penalties paid. It
is highly unlikely that any court would accept the
argument that a fine or penalty was a necessary cost
to obtain inventory. Therefore, by denying this
inclusion, the regulation prevents these expenditures
from becoming indirectly deductible by increasing the
cost of goods sold.

The IRS applied the rule
even more expansively in Technical Advice Memorandum
200629030.47
In this ruling, the taxpayer was facing a
possible fine for violating federal environmental law.
The taxpayer agreed to a settlement of all claims with
the government. The settlement required the taxpayer
to build a beneficial environmental project (BEP). The
taxpayer capitalized and depreciated the cost of the
project, but the IRS denied part of the depreciation.
The question raised by the letter ruling is whether
the total costs of the BEP were capitalizable under
Secs. 263A or 1012.

The initial inquiry was
whether the expenditures would be nondeductible under
Sec. 162(f) if they were not capitalizable. The
taxpayer argued that since no fine or penalty was ever
levied and formal proceedings were not opened, Sec.
162(f) did not apply. The government, based on the
origin of the claim doctrine, looked beyond the fact
that no fine had been levied to conclude that the
expenditures had their origin in an environmental law
violation and were incurred to prevent the imposition
of a fine. Since they were in lieu of a fine that was
designed to be punitive, the expenditures met the
definition of a fine or penalty under Sec. 162(f).
This is consistent with the regulations under Sec.
162(f) that deny a deduction for settlements of actual
or potential criminal or civil fines and
penalties.

Having ruled that the expenditures
were the equivalent of a fine, the government examined
the rules of Sec. 263A. Under Sec. 263A(a)(2), only
expenses that would be deductible absent Secs. 263(a)
and 263A are capitalizable. Since these expenditures
would not be deductible because of Sec. 162(f), they
are not included in the depreciable basis of an asset
under Sec. 263A.

Finally, the government turned
to Sec. 1012. Nothing in this section or its
regulations makes any reference to fines, penalties,
or Sec. 162(f). However, according to the government,
the violation of public policy doctrine applies to
Sec. 1012, and therefore the taxpayer may not include
these amounts in basis. The government acknowledged
that the doctrine was codified and limited in Sec.
162(f). However, in the absence of Code or regulation,
the IRS argues that as a common law rule of federal
income tax law, the doctrine continues to apply. The
implication is that the IRS can apply the broad
judicial doctrine in any case where Congress or
Treasury have not specifically limited it to fines or
penalties.

Observation: A better argument
would be that allowing the expenditure to be
capitalized would have resulted in an indirect
deduction, which would conflict with Treasury’s policy
as stated in Regs. Sec. 1.471-3(d) and Sec. 263A
discussed above.

Although the ruling’s broad
conclusions are subject to questions, disallowing an
indirect deduction through depreciation in this case,
for an amount that would be nondeductible under Sec.
162(f), is a reasonable application of the intent of
Congress.

Sec. 165

Sec. 165 permits
taxpayers to deduct losses not compensated by
insurance. Losses deductible by individuals are
limited by Sec. 165(c) to losses incurred in a
business, a transaction entered into for profit, and
casualty and theft losses. Neither the Code nor the
regulations has been changed to address the violation
of public policy doctrine as it applies to losses
under Sec. 165 following the passage of Sec.
162(f).

In Richey,48 a case that predates the
enactment of Sec. 162(f), the taxpayer deducted
$15,000 under Sec. 165. The loss arose as part of a
plan to counterfeit U.S. currency, which was in fact a
plan to defraud the taxpayer of money. The Tax Court
denied the deduction on the grounds that it would
violate the clearly defined policy against
counterfeiting money. Therefore, the rules for
nondeductibility of expenditures that violate public
policy were consistent under Secs. 162 and 165 prior
to 1969.

The IRS believes, despite the
enactment of Sec. 162(f), that it can still deny
deductions under Sec. 165 based on a violation of
public policy. In Rev. Rul. 77-126,49 the IRS stated that the
public policy doctrine still applies to Sec. 165 since
Congress did not change this section when it enacted
Sec. 162(f). The IRS repeated this conclusion in Rev.
Ruls. 81-24 and 82-74.50

The Tax Court and
other courts have also held that the public policy
doctrine still applies. The Tax Court used the
violation of public policy to deny a deduction in
Mazzei,51 another counterfeiting
scheme, under Sec. 165 following enactment of Sec.
162(f). The majority felt that the case was ruled by
Richey and
did not discuss what, if any, impact Sec. 162(f)’s
enactment had on the viability of the doctrine or the
precedential value of cases decided before its
enactment.

Similarly, in Wood,52 a case involving a
forfeiture related to illegal drug smuggling, the
Fifth Circuit disallowed a loss under Sec. 165 because
it would violate public policy. As authority the court
cited Holt,53 another drug forfeiture
case, which also disallowed a loss using the public
policy doctrine. Holt, in turn,
cited pre-1969 cases without discussing the impact of
the enactment of Sec. 162(f). Reviewing the post-1969
cases that have applied the public policy doctrine,
each relied on a pre-1969 precedent.

Not all
courts and judges have ignored the enactment of Sec.
162(f) while analyzing deductions under Sec. 165. For
example, the dissent in Mazzei points out
that Congress, when it enacted Sec. 162(f), stated
that public policy beyond fines and penalties was not
defined clearly enough to deny a deduction. The
dissent would therefore not apply the doctrine under
Sec. 165 to deny deductions. The Second Circuit raised
the question in Stephens, finding
that “the public policy considerations embodied in
Section 162(f) are highly relevant in determining
whether the payment . . . was deductible under Section
165.”54 The Tax Court majority
raised but did not address the question of the effect
of the enactment of Sec. 162(f) on the public policy
doctrine in Medeiros.55

Proposal

The authors believe that the enactment of Sec.
162(f) does affect the application of the public
policy doctrine under Sec. 165 and endorse the
approach taken by the Tax Court and the Second Circuit
in Murillo.56 In this case, the courts
limited the denial of a deduction to an expenditure
that was the equivalent of a fine by applying the
rules of Sec. 162(f) rather than a general public
policy doctrine to Sec. 165. By limiting the denial of
deductions to fines and penalties, the courts would
apply Sec. 165 consistently with Congress’s and
Treasury’s approach to Secs. 162, 212, 471, and 263A.
This approach is consistent with the congressional
belief as stated in the committee reports on Sec.
162(f) that public policy in other cases is too
uncertain to be applied consistently and reasonably.
It also eliminates the perceived conflict in prior
court decisions regarding when public policy is
sufficiently clear and the resultant frustration
sufficiently severe to justify denying a loss
deduction. It is hoped that future court decisions
will limit the denials under Sec. 165 to items
nondeductible under Sec. 162(f).

It has been
argued that Congress did not intend to limit the
public policy doctrine to fines and penalties. One
commentator57 points out that the
complete statement in the Senate report states
that

[t]he
provision for the denial of the deduction for payments
in these situations which are deemed to violate public
policy is intended to be all inclusive. Public policy,
in other circumstances, generally is not sufficiently
clearly defined to justify the disallowance of
deductions.58

The commentator
argues that the use of the word “generally” indicates
that there are cases beyond fines and penalties where
Congress intended that the violation of public policy
doctrine should apply.

Congress enacted Secs.
162(c) and (g) at the same time as Sec. 162(f). Sec.
162(c) denies a deduction for illegal bribes,
kickbacks, and other payments, while Sec. 162(g)
denies a deduction for treble damage payments under
antitrust law. The authors believe that the Senate
report uses the word “generally” to acknowledge that
the deduction denied in Secs. 162(c) and (g), similar
to the fines and penalties under Sec. 162(f), is
denied under the violation of public policy doctrine,
rather than to imply that additional expenditures
should be denied under the doctrine.

The
authors propose that the use of the violation of
public policy doctrine under Sec. 165 be limited to
expenditures that would be nondeductible under Sec.
162(f). To analyze this proposal, we review three
troublesome issues: forfeitures, casualties, and
thefts.

Forfeitures

Holt is a
typical forfeiture case.59 The taxpayer was engaged
in transporting and selling marijuana. He was arrested
and his truck, which he was using to transport the
drugs, was seized and forfeited. The Tax Court held
Sec. 165, not Sec. 162, governed the losses sustained
from the forfeiture. It held that the deduction should
be disallowed because allowing it would violate public
policy.

Wood is
another forfeiture case.60
The taxpayer received commissions on sales
of marijuana and invested those commissions in real
estate. He pled guilty to importing marijuana and
forfeited the real estate since it was purchased with
money he earned from his marijuana activities. The
Fifth Circuit held that the difference between a
forfeiture of property used in a drug business and
property acquired with profits from the illegal
business was immaterial. It then cited Holt to conclude
that the loss was nondeductible under Sec. 165 because
it violated public policy.

The court considered
and rejected Wood’s argument that his case was
distinguishable from prior cases because his
forfeiture was a civil action and not a criminal
action. In the court’s opinion, all forfeitures
related to drug trafficking are economic penalties
that augment the criminal fines and penalties, so
deducting them would violate the public policy
doctrine.

In Murillo, the Second
Circuit took a better approach to the problem that
incorporated Sec. 162(f).61 The taxpayer pled guilty
to structuring bank accounts to avoid federal
financial reporting requirements. He forfeited some
unrelated individual retirement accounts as part of
the plea agreement. Since he had previously reported
the accounts as income, he claimed a loss on the
forfeiture. Although the court referred to the public
policy doctrine, it concluded that the forfeiture was
nondeductible because it was a fine or penalty as
defined in Sec. 162(f). It cited the Supreme Court’s
decision in Bajakajian,62 a nontax case, for the
conclusion that all forfeitures are fines if they
constitute punishment even in part. Therefore, based
on Murillo
and Bajakajian, all
forfeitures that have punitive aspects are fines and
would be nondeductible using the recommended approach
without having to rely on the old violation of public
policy doctrine.

Casualties

The second issue to consider is the deduction of
casualty losses under Sec. 165. In Blackman,63 the taxpayer’s employer
transferred him from Baltimore to South Carolina. His
wife did not like South Carolina and so moved back to
Baltimore. On a visit to Baltimore, the taxpayer found
another man living with his wife. The taxpayer and his
wife quarreled, and several days later he went to
their house and took some of her clothes, put them on
the stove, and set them on fire. The fire spread
throughout the house and destroyed it. The taxpayer
claimed a loss under Sec. 165.

The IRS conceded
that the taxpayer suffered a loss due to the fire but
argued that the loss was nondeductible since it was
set intentionally and allowing the deduction would
violate public policy. The Tax Court stated that the
taxpayer was entitled to a casualty loss deduction
unless he was grossly negligent. It found that he was
grossly negligent and that the public policy doctrine
barred the deduction. The conclusion is correct;
however, the court could have simplified the analysis.
For the fire loss to be deductible, it must qualify as
a casualty. A fire that a taxpayer sets himself is not
a casualty because it is a knowing and willful act by
the taxpayer.64 Therefore, the Tax Court
could have ruled it nondeductible without having to
resort to the violation of public policy doctrine.
True casualties are deductible under Sec. 165(c);
deliberate actions that violate public policy are not
casualties. Therefore, the suggested approach to Sec.
165 will yield the correct outcome.

Theft

The final issue to be
considered is the deduction of theft losses.
Individuals normally can deduct theft losses under
Sec. 165(c). However, if a co-conspirator in a related
criminal venture perpetrates the theft, should the
taxpayer be allowed a deduction?

In Edwards v.
Bromberg,65 the Fifth Circuit
allowed the taxpayer to claim a deduction. The
taxpayer gave money to an individual who told the
taxpayer that he had fixed a horse race and the
taxpayer’s money would be bet on the prearranged
winner. In reality, the recipient kept the taxpayer’s
money. The court allowed the deduction without any
reference to the violation of public policy
doctrine.

On the other hand, the Tax Court denied
a deduction in Richey.66 As previously mentioned,
this was a putative counterfeiting scheme. The court
denied the deduction on the grounds that allowing it
would violate public policy. The court did not cite or
refer to Edwards v.
Bromberg.

The Tax Court reconsidered the
deductibility of theft losses in Mazzei,67 another putative
counterfeiting scheme that resulted in the taxpayer’s
being swindled out of funds he transferred. The court
again used violation of public policy to deny the
deduction. The court distinguished Edwards v.Bromberg on the
grounds that the taxpayer in that case did not intend
to participate in “fixing” the race. This distinction
is questionable since the taxpayers in both Richey and Mazzei were not
going to do the counterfeiting but were simply
providing the cash to be used. This appears to be the
same type of action as a taxpayer who supplies cash to
be used to bet on a “fixed” horse race. One judge
dissented on the grounds that Edwards v.
Bromberg controlled the result, and another
dissented on the grounds that it is possible to read
the Senate report on Sec. 162(f) as restricting public
policy to fines and penalties. Even if it is not so
restricted, it does require limited use of the
doctrine; this limited use is not justified under
these facts, according to the second dissent.

The results of these three cases leave doubt as to
which theft losses will be nondeductible under the
public policy doctrine. The proposed approach of
limiting the public policy exception to deductibility
would permit the deduction, consistent with Edwards v.
Bromberg. The authors believe that if Congress
wants to deny these theft loss deductions, it must
amend the Code. Currently, gambling losses are limited
to the amount of gambling winnings reported in the
same year.68 If Congress adopted a
similar approach for theft losses associated with
criminal activities (i.e., limiting theft losses and
other deductible expenditures in criminal activities
to the income reported in the activities), it would
settle the issue of violating public policy in a
rational fashion and would also prevent criminal
losses from offsetting legal income.

Conclusion

Over time the courts have
developed a doctrine that denies a deduction for any
expenditure that violates a narrowly defined public
policy. In 1969, Congress codified this doctrine and
limited it by enacting Sec. 162(f), which denies
deductions for fines and penalties. Since 1969, the
IRS and some courts have continued to apply the
violation of public policy doctrine to deny deductions
under Sec. 165 for losses other than those
attributable to fines and penalties.

A better
approach would be to deny losses under Sec. 165 for
expenditures that would not be deductible under Secs.
162(c), (f), or (g). This would create a consistent
rule for business expenditures and expenditures
incurred to produce income. If Congress wants to deny
expenditures that violate other specific public
policies, such as criminal activities, it should amend
the Code. Since the tax law originally was not
designed to modify behavior, the amendment should
limit the deduction to the amount of income reported
from these “unacceptable” activities and
behaviors.

4 The major exception is
expenses related to the sale of illegal drugs, which
are nondeductible under Sec. 280E.

5 For a more complete
discussion of the policy issues, see Taggart, “Fines,
Penalties, Bribes and Damage Payments and Recoveries,”
25 Tax L. Rev.
611 (1969–1970).

6 For a detailed discussion
of the pre-1969 cases, see Manns, “Internal Revenue
Code Section 162(f): When Does the Payment of Damages
to a Government Punish the Payor?” 13 Va. Tax Rev. 271
(1993–1994).

31 In Talley Indus.,
Inc., 116 F.3d 382 (9th Cir. 1997), the Ninth
Circuit reversed the Tax Court’s decision to permit a
deduction because a finding that a payment is
compensatory for double jeopardy purposes did not
automatically make it compensatory for purposes of
Sec. 162(f). This case raises additional questions
about the compensatory payment exception.

38Fresenius Med. Care
Holdings, Inc., No. 08-CV-12118-PBS (D. Mass.
6/25/10). It should be noted that the government based
its argument on the Justice Department’s tracking
document, the value of which has been questioned. See
Elliott, “Tracking Document Is of Least Significance
in Government Settlement Taxation, IRS Official Says,”
2010 TNT 186-7 (September 27, 2010).

Edward Schnee is the Hugh Culverhouse Professor of
Accounting and director of the MTA Program at the
University of Alabama in Tuscaloosa, AL. Eugene Seago
is the R. B. Pamplin Professor of Accounting at
Virginia Polytechnic Institute and State University in
Blacksburg, VA. For more information about this
article, contact Prof. Schnee at eschnee@cba.ua.edu.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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